When it comes to making predictions about stocks, most of us fall victim to human nature. In order to improve our performance, we first need to understand these common psychological pitfalls and then take the proper steps to address them.
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Can you predict the future? Even the weatherman has trouble figuring out if it is going to be partly cloudy, mostly sunny, or if a blizzard will pass through today. Investment analysts are also horrible at predicting the future. Chances are you're not very good at making predictions, and neither am I. Why? It's simply human nature. A primary function of conducting an investment analysis is to review all of the facts surrounding a company, its industry, and its future prospects and draw conclusions based on this information. Unfortunately, investors fall victim to human nature, which often results in interpreting those facts in some biased manner. The problems with human nature include linear perception, group think, and messenger syndrome. Linear perception For example, Sun Microsystems (Nasdaq: SUNW) and EMC (NYSE: EMC) were experiencing accelerating revenue growth rates for many quarters. If you had used the past to predict the future, you would have been consistently behind the curve as the growth of the Internet infrastructure build-out accelerated each quarter's results beyond expectations. Then almost overnight, growth slowed to a screeching halt because of the weakening economy. If you had extrapolated the accelerating growth rates to predict future outcomes, you would have been behind the curve again. Extrapolating from the past to predict the future is like driving your car while looking through the rearview mirror -- it can be very dangerous. Group think Group think -- among many other factors -- is part of why mutual fund managers tend to underperform the stock market indexes. Many managers attend the same meetings with the same companies and brokerage analysts. They get the same information, ask the same questions, and draw the same conclusions. If everyone else is doing the same thing, then it is safe because if everyone is wrong together, it's likely that no one will lose his job. Messenger syndrome For example, when I wrote about some risk factors facing shareholders of Oracle Corporation (Nasdaq: ORCL) -- a company I own shares of -- I was called a liar, accused of being short the stock, and even received a death threat. All of this for discussing risk factors that any investor should be aware of if they own a stock. As a result of messenger syndrome, information disseminated to the investing public becomes positively biased. Then, when a company experiences trouble -- such as Lucent Technologies (NYSE: LU) with its accounting problems -- everyone wonders why they never saw it coming. How do I prevent this from happening to me? Second, ask yourself, "What's wrong with this picture?" In other words, actively seek out contrary viewpoints and weigh their merit against the positive information you have uncovered. Get a balanced view of any company. Third, when you draw conclusions from facts and make predictions, make sure you have a margin of safety built in to your expected outcome. It is very likely that future events will not unfold as you predicted, but if you leave some "breathing room" in your analysis for inevitable errors, then you will be better positioned to cope with the unpredictable. If all of this seems difficult, well, that's the point. It's not supposed to be easy. If you don't feel inclined to put a lot of work into your investments -- especially during frothy bull markets and debilitating bear markets -- buy an index fund and forget about all of this "nonsense." At the time of publication, John Del Vecchio owned shares of Oracle. You can view the rest of his holdings in his personal profile. The Motley Fool is investors writing for investors.
Linear perception refers to the fact that people often assess past performance and extrapolate that data to make predictions about the future. While it is important to understand the past to gain an understanding of where a company has been and where it may be headed, the stock market only discounts the future, not the past.
The problem with group think is that people feel more comfortable embracing the consensus view of a company's prospects than expressing a contrary viewpoint. Analysts' earnings estimates seldom differ significantly from the consensus opinion. They would rather be wrong together than risk being wrong alone.
Messenger syndrome results from wanting to "kill the messenger" when she is the bearer of bad news. Analysts are hesitant to discuss anything negative about a stock for fear of being ridiculed by colleagues, or worse, being fired. It is easier to tell people what they want to hear rather than discuss pertinent facts that may be unpleasant to shareholders of a company.
Well, human nature is not easy to overcome. First, make sure you're thinking for yourself. Develop your critical thinking skills so you can wade through all of the information available and discern what really matters from what is just "noise." If you have a different perception from the rest of the crowd, chances are you may be on to something -- as long as it is rational.
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